For some reason, bonds have not been as popular with investors as equities. Some find them complicated - others think they are boring. As this article will explain, they are neither.

In the simplest terms, bonds are a loan, made by you, to a government or company when they need to raise additional capital.

Bonds issued by the British Government are called gilts. Bonds issued by a company are called corporate bonds.

Rather than invest in bonds directly, many people prefer to invest in a bond fund.

What's the difference between a bond and an equity? Over the past few years, a growing number of UK investors have become comfortable with one form of investment - buying and selling shares.

These are a way of owning part of a company, sharing in its success and failure.

When equity markets fall, the value of equity investments fall. Spotting a good company at the right time is part of the excitement, but it is also part of the risk.

Bonds, on the other hand, are generally affected by changes in interest rates and inflation rather than fluctuations in the stock market. And their prices move less sharply than equities - so they are often regarded as a safe haven from stock market turbulence.

However, as neither bonds nor equities are free of risk, it makes sense to reduce the risk to your investment by diversifying your portfolio to hold a combination of bonds and equities.

How bonds work: When you invest in a bond fund your money is pooled with other investors' money and invested in a wide range of individual bonds. This way, any risk to your investment is reduced, since you are not reliant on the fortunes of a single company or government. You also benefit from having an experienced bond fund manager watch over your investment.

Risk and Reward: Although bonds offer lower risk than equities they are not entirely risk free.

The level of risk is based on economic factors and the ability of the bond issuer to maintain the interest payments and repay the face value at maturity.

Bonds that have been issued by the government are perceived as being low risk. Corporate bonds carry a higher level of risk, as the issuing companies are more likely than the government to default on the interest payments or fail to repay the face value of the bond at maturity. To compensate for the increased risk, they offer a higher interest payment than government bonds.

Both funds are an income generating investment, therefore they will appeal to anyone with an income need, such as someone nearing retirement. In times of low inflation, investing in bonds is a good way of maintaining a stream of income that will have a high 'real' value.

In addition, in times of low interest rates, the income received from a bond fund investment will be higher than that offered by the building society.

Additionally, someone who already has investments in the stock markets might choose to invest in a bond fund in order to diversify the level of risk to which their savings are exposed. The answer as to which bond fund is right for you depends on how averse you are to taking a bit of risk to increase your potential return.

Gilts: If you are looking for a solid belt and braces investment that will pay you a regular income, you should consider investing in gilts, because, as mentioned earlier, UK gilts are the safest of all bond investments.

Corporate Bonds: If you are prepared to take more risk, in the hope of better returns, you might want to consider corporate bonds.

Corporate bonds are a rapidly expanding area of the market. As they are issued by companies rather than the Government, they offer a higher interest payment than gilts because companies have a higher risk of default than the government.

The interest payment varies according to the financial strength of the company. Credit ratings, which are assigned by internationally recognised rating agencies, offer a guide to a company's financial strength.

A company's credit rating can be affected by its changing circumstances. For example, the takeover of a company with highly rated corporate bonds by a lowly rated predator may result in a downgraded rating.

High yield corporate bonds: If you are prepared to take more risk, in return for an even higher income, you could benefit by investing in high yield corporate bonds.

Currently, better quality high yield corporate bonds pay around three per cent to five per cent above similarly dated gilts.

When comparing the make-up of funds, a good starting point is the type of bonds and the range of credit ratings in which the fund invests. You also need to know if the fund has a high risk profile due to equity exposure by holding quasi-equities, such as convertibles, preference shares or even direct equity holdings.

- John Dresser is an independent retirement planning specialist and director at Hennessey and Partners based in Darlington. He can be contacted on (01325) 488556.

Published: 17/06/2003